The Consumption - Real Exchange Rate Anomaly: an Asset Pricing Perspective

Mathias Hoffmann and Thomas Nitschka

No 331, IEW - Working Papers from Institute for Empirical Research in Economics - University of Zurich

Abstract: Idiosyncratic consumption risk explains more than 60 percent of the cross-sectional variation in quarterly exchange rate changes and currency returns. Our results are obtained from data of 13 industrialized countries and are based on an international version of the consumption capital asset pricing model (CCAPM) in which we account for international consumption heterogeneity. We use this framework to dissect the consumption-exchange rate anomaly, the empirical fact that international variation in purchasing power alone does not appear to account for differences in consumption growth rates across countries. As an explanation for this phenomenon, we explore the presence of currency risk premia that also lead to departures from uncovered interest parity (UIP). We decompose the cross-sectional variation in consumption into one component that is due to cross-country differences in inflation rates and a second component that is due to international variation in nominal interest rates. We interpret these factors as indicators of goods and financial market segmentation respectively. We find that both help account to virtually equal parts for the cross-section of exchange rate changes. Interestingly, the price of aggregate consumption risk has declined over the 1990s, in line with a growing literature that documents a growing internationalisation of country portfolios over this period.

Keywords: Uncovered interest rate parity; consumption CAPM; international financial integration; consumption risk sharing (search for similar items in EconPapers)
JEL-codes: E21 F30 G12 (search for similar items in EconPapers)
Date: 2007-09
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mac
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Persistent link: https://EconPapers.repec.org/RePEc:zur:iewwpx:331

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